While leverage is useful in normal times, it consumes market liquidity in bad times.
Oxford,Oxfordhisre (PRWEB UK) 23 November 2015
With the threat of a global financial crisis, regulators, central banks and researchers need to focus more on leverage constraints (a trader’s ability to borrow in order to invest in risky assets), as these can have a negative impact on market liquidity.
New Oxford research tested on the unique features of the margin trading system in India shows how these leverage constraints, which have been traditionally ignored in the past by regulators, can impact a stock markets liquidity either negatively or positively.
The research paper “Leverage constraints and liquidity” by Dr Bige Kahraman, Associate Professor of Finance, Oxford Saïd and Heather Tookes, Professor of Finance, Yale School of Management; uses Indian capital markets as a testing ground, in which they are able to quantify the impact of leverage on liquidity.
In 2004, Indian regulators introduced a formal margin trading system that allows traders to borrow in order to finance their purchases of securities. The unique features of this system are that:
(1) Only some exchange-traded stocks are eligible for margin trading.
(2) The list of eligible stocks is revised every month.
According to the authors of the report, liquidity is higher when stocks become eligible for margin trading. With the Indian margin system as an example, the research showed that over the course of a year, reduction in trading costs due to margin eligibility, gave an annual saving of about 3 million rupees per stock.
This transaction cost saving with margin trading eligibility is very significant, given that there were more than 1,500 stocks in eligible groups during this same period.
However, the research also shows that leverage constraints have important costs. Traders’ leverage leads to the increase of negative shocks in times of market stress. Margin eligible stocks have much worse liquidity in bad times due to downward liquidity spirals triggered by traders’ reducing the level of debt by rapidly selling assets.
Dr Kahraman said: ‘Our findings about the impact of leverage constraints on liquidity should be of particular interest to policy makers thinking about imposing or relaxing restrictions on leverage. While leverage is useful in normal times, it consumes market liquidity in bad times. The optimal policy should consider the probability of the bad states of the world. Regulators, central banks and researchers traditionally have focused only on interest rates, and ignored leverage. However, as we learned from our study as well as the recent financial market crisis of 2007-2008, monitoring leverage can substantially help with avoiding the harmful effects of leverage.’
The research can be found here.
For further information or to speak with Dr Kahraman please contact the press office:
Jonaid Jilani, Press Officer, Saïd Business School
Tel: +44 (0)1865 614678, Mob: +44 (0)7860 259996
Kate Richards, Press Officer, Saïd Business School
Tel: +44 (0)1865 288879, Mob: +44 (0)7711 000521
Notes to editors
About Dr Kahraman
Dr Bige Kahraman is an Associate Professor of Finance at Saïd Business School since 2015. She holds a PhD in Economics from Yale University, with specialisations in Financial Economics and Econometrics.
Her research focuses on understanding the role of market frictions on market efficiency and allocation of capital. She is also a Fellow at Kellogg College, University of Oxford.
About Saïd Business School
Saïd Business School at the University of Oxford blends the best of new and old. We are a vibrant and innovative business school, but yet deeply embedded in an 800 year old world-class university. We create programmes and ideas that have global impact. We educate people for successful business careers, and as a community seek to tackle world-scale problems. We deliver cutting-edge programmes and ground-breaking research that transform individuals, organisations, business practice, and society. We seek to be a world-class business school community, embedded in a world-class University, tackling world-scale problems.
In the Financial Times European Business School ranking (Dec 2014) Oxford Saïd is ranked 10th. It is ranked 10th worldwide in the FT’s combined ranking of Executive Education programmes (May 2015) and 22nd in the world in the FT ranking of MBA programmes (Jan 2015). The MBA is ranked 7th in Businessweek’s full time MBA ranking outside the USA (Nov 2014) and is ranked 5th among the top non-US Business Schools by Forbes magazine (Sep 2013). The Executive MBA is ranked 2nd worldwide in the Economist’s Executive MBA ranking (Sep 2015) and 9th worldwide in the FT’s ranking of EMBAs (Oct 2015). The Oxford MSc in Financial Economics is ranked 14th in the world in the FT ranking of Masters in Finance programmes (Jun 2015). In the UK university league tables it is ranked first of all UK universities for undergraduate business and management in The Guardian (Jun 2015) and 2nd in The Times (Sept 2015). For more information, see http://www.sbs.ox.ac.uk/